“Achievement is talent plus preparation.”
Kitchen and Bath firm owners could earn a much higher gross profit annually by simply changing their pricing methodology and commission system. SEN has observed that too many owners absorb costs that should be built into project markups and commission payouts.
Kitchen and bath firm owners can resolve this situation by properly budgeting for their business and creating the correct pricing structure for their products and services. The core issue is that most dealers don’t realize the functional connection between the company’s annual budgeting process and a price formula system.
In this advisory, you’ll find three key steps that show you how to properly price projects for your overhead and desired net profit, so you can maximize your firm’s annual gross profit starting with your next job.
Overview of the task: Why calculating the burden rate is crucial to your firm
The purpose of a price formula system is to collect the gross profit dollars established in your firm’s annual budget. This is accomplished in a three-part process.
- Calculation of the production overhead burden rate.
- Calculation of the respective markups for each business mix category.
- Establishment of a service contingency percentage.
Step 1: Calculating the burden rate
If we consider indirect labor expenses, how do you properly job cost before paying your sales designers their percentage share of the gross profit? The answer is the creation of a burden rate – based upon a comprehensive annual company budget – that covers indirect labor expenses in the form of a calculated percentage.
Indirect labor and production expenses include a project manager’s salary, delivery truck operations, warehouse rental space, et cetera. Owners who do not do the proper job costing end up overpaying their sales designers and under collecting the firm’s overhead.
How to develop the burden rate
Let’s consider a remodeling operation of $3,000,000. We’ll remove appliances from the burden calculation. We do this because including devices in the burden rate would seriously reduce the firm’s competitiveness in selling them.
- Subtract highly competitive cost items from the total cost of sales.
Let’s assume the budget for the firm’s $3,000,000 operation calls for $550,000 in appliance revenue at a 25% gross profit:
Total Income = $3,000,000 100.0%
Less Budgeted Gross Profit = – 1,615,000 41.0%
Total Cost of Sales = $1,385,000 59.0%
Less Appliance Cost of Sales -412,500
Sub-Total Cost of Sales = $ 972,500
- Subtract the total production overhead budget from the sub-total cost of sales. Assume the production overhead for this $3,000,000 operation is $140,000.
Sub-Total Cost of Sales = $972,500
Less Production Overhead = -140,000
Net Cost of Sales = $832,500
- Divide the budgeted production overhead by the net cost of sales. Then round up for the error.
Production Overhead = $140,000 = 16.8% round to 17%
Net Cost of Sales $832,500
In this case, a burden rate of 17% should be added to the cost of sales (including material costs, use tax, direct labor, and subcontractors), but exclusive of appliances. Make sure to check the accuracy of your burden rate quarterly and make adjustments as needed.
Owners who opt not to fix a burden rate into their pricing formula and commission system are losing tens of thousands of dollars of the annual net profit.
Step 2: Markup Calculation
You utilize a markup to finance your firm’s sales and administrative expenses, miscellaneous expenses, and the net profit established in your company budget.
Since most dealers sell to different market categories, kitchen and bath firm owners will find it instructive to develop other markups over their burden rate based on their firm’s expected business in each category for the year.
Let’s use the hypothetical $3,000,000 revenue from the previous sample operation in the following strategy chart. You’ll notice that the diagram depicts the necessary minimum markups for four different market categories.
Market Category Mix % Revenue GP% GP $ Markup Min GP
Kitchen – Remodel 70% $2,100,000 43% $903,000 1.79 – 1.85 4.1%
Kitchen – New House 10% $300,000 38% $114,000 1.65 – 1.70 39.4%
Appliances 10% $300,000 25% $75,000 1.34 – 1.37 25.4%
Bathrooms 10% $300,000 46% $138,000 1.92 –1.97 47.9%
TOTALS 100% $3,000,000 41% $1,230,000
With all the moving parts in kitchen and bath remodeling projects, owners should allow for 1-3% gross profit slippage in their markups. This strategy will cover the errors – from a wide range of sources such as cabinet order oversights to installer molding miscuts – typically happening during a job. In this sampling, 1% slippage is built into all category markups except appliances.
The minimum markup for kitchen remodeling projects is 1.79 or 44.1%, while the suggested markup for this category is 1.85. This minimum is 1.1% higher than the budgeted 43% gross profit. Since bathrooms present complex production challenges and financial rewards, your company should earn a higher gross margin on these projects. Hence the 1.92 minimum markup.
Sales incentive compensation is typically based on a percentage of the gross profit of a job. So your company should establish a range of acceptable markups per market category. The minimum is stipulated, so team members don’t undersell a job without being penalized on their share of the gross profit dollars. And the maximum markup is defined so your customers are not price-gouged, which could negatively impact future referral business. The best sales designers will always seek to achieve the highest markup, especially if they sense the client will need much hand-holding.
Step 3: Service Contingency
The third component of an effective pricing system considers the costs incurred servicing jobs within a one-year warranty.
Ten months before a job closes, a subcontractor sends you a $200 invoice for adjusting doors and rollouts on the Smith job. This cost should not be posted to the cost of sales if the project was already closed out, and the commission paid to the sales designer. Instead, it should be assigned to an account called warranty service, which is located below the line on your profit and loss statement in an area of the P&L known as other income and expenses.
To finance the collection of warranty service expenses, a 1-3% service contingency should be added to every job after the burden rate and markup, exclusive to any appliances’ selling price.
The sales designer should not share these gross profit dollars generated through this price formula. This revenue stream is exclusively for servicing warranty work where labor is required to fix problems and preserve the dealer’s reputation. If all the warranty dollars budgeted into the price formula are not used in any given year, they add to the company’s bottom line.
Let’s put these three steps together in an example of what an overall pricing model should look like.
Pricing Model for Projects
Total of Material, Use Tax, Labor, & Subcontract Costs = $50,000
Burden Rate: 1.17 = $8,500
Sub-Total = $58,500
Minimum Markup: 1.79 – (Kitchen Remodel Gross Profit) = $46,215
Sub-Total = $104,715
Warranty Service: 1.02 = 2,095
TOTAL BASIC JOB = $106,810
Appliance Selling Price (at 1.34 Markup) = $19,000
7% State Sales Tax = 1,330
TOTAL SELLING PRICE = $127,200
What percentage of the $46,215 gross profit should be shared with your sales designer? It could range between 10% and 33%. Their rate would depend upon:
- The salesperson’s job description
- Whether this is a base salary or not
- Your firm’s level of support services (i.e., Design Assistant, Project Manager, etc.)
- The salesperson’s experience and skill level
SEN strongly believes there should be a singular pricing methodology per market category to collect the necessary gross profit dollars, thereby financing a firm’s production burden, direct overhead, and desired net profit.
We also favor support services and straight commission compensation (25-33% of the gross profit) for sales designers so (a) they become more efficient and productive and (b) customers receive prompt first-class service.
Three takeaways from this advisory:
- Reverse engineer to determine your budget’s required gross profit dollars.
- Create a price formula system, as illustrated in step one, so you can collect all the gross profit dollars prescribed in the company budget.
- Develop a marketing plan to achieve revenue and gross profit percentage goals.
—SEN Leadership Team
Master strategic planning, selling more into each job, leveraging technology, Good-Better-Best selling, and other intelligent implementations at one of SEN University’s valued online business courses. The pricing concepts mentioned in this advisory are covered in much greater detail in our 4-Day Executive Business School happening October 24-28. Or contact us to attend our in-person schools.